That means regulators having the power to fully break up a bank if it does not follow the ring-fence proposals.

The bank reforms will go before Parliament early next year.

'Electrification'

The Parliamentary Commission on Banking Standards, known as the Banking Commission for short, was asked by Chancellor George Osborne to study the draft version of the government's Financial Services (Banking Reform) Bill.

This follows last year's recommendation by the Independent Commission on Banking, which was led by Sir John Vickers.

Sir John concluded that ring-fencing was the best way to protect "core" retail banking activities from any future investment banking losses, such as were seen during the global financial crisis.

The Commission explained

The Parliamentary Commission on Banking Standards was appointed in July following the Libor scandal and other episodes that damaged the reputation of banks in the UK

It includes MPs and peers and is chaired by Andrew Tyrie, who also heads the House of Commons' Treasury Committee

Members include the next Archbishop of Canterbury, Justin Welby

It heard evidence from major figures in the banking sector

Evidence included a warning from RBS boss Stephen Hester that ring-fencing banks' retail and investment arms could increase the risk of institutions needing to be rescued

But Barclays chief executive Antony Jenkins told the commission that his bank was "embracing" the ring-fencing proposal

The commission has also heard from Paul Volcker, a former chairman of the US Federal Reserve, about his US proposals to ensure bank safety

ensuring that bank losses fall on bank creditors and not depositors or taxpayers

making banks better able to absorb losses

But the government's draft legislation was a watered-down version of the Vickers report which proposed quite a high degree of separation, said Andrew Tyrie, chairman of the Banking Standards Commission.

"The proposals as they stand [in the Bill], fall well short of what is required," he said.

"What we've done with the Commission proposals is to put back some of that stiff separation into the ring-fence and then make clear that the key problem - that banks are going to be at the ring-fence all the time, which will be a nightmare for regulators - needs to be dealt with," he told BBC Radio 4's Today programme.

"And the way to do that is to say to banks 'If you don't try to game this ring-fence we won't see the need to separate you.'

"Then they will have a massive incentive to get to a point where banks have certainty [not to be broken up]."

"That is why we recommend electrification. The legislation needs to set out a reserve power for separation - the regulator needs to know he can use it."

Ring-fencing explained

Under the draft bill, ring-fencing would ensure that retail services of a struggling lender can be carried on independently and smoothly even if authorities let the rest of the group fail.

For example, in the case of a failing banking group, regulators could sell off its core activities - thereby maintaining continuity for depositors - while allowing the rest of the organisation to go through a bankruptcy process.

Secondly, retail deposits (but not pension liabilities) would be ranked ahead of the claims of other bank creditors in the event of a bank insolvency.

Thirdly, banks are to hold a sufficient capital buffer - as outlined by global regulators - which means that if banks do fail, losses can be absorbed by shareholders and other creditors rather than the taxpayer.

Ring-fenced banks would also be prohibited from carrying out a range of investment and wholesale banking activities, including the sale of complex derivatives, which are highly complicated contracts designed to hedge borrowers against certain risks but can lead to heavy losses if they go sour.

But in a concession, the Banking Commission proposal agreed to the use of simple derivatives, such as currency hedges, for banks within the ring-fenced body.

Under the draft legislation, the Treasury would have the authority to decide which banks ring-fencing should apply to, as well as specific activities to be undertaken within ring-fenced banks.

The Prudential Regulation Authority, which will become the UK's regulator for deposit-taking institutions in April under the Bank of England, would have the power to ensure the ring-fenced bank to carry on with its business.

'Common view'

Mr Tyrie has also called on independent reviews of the effectiveness of the ring-fence proposals across all banks to take place at least once every four years.

"Remember at the moment banks will probably behave, but in the long run they will find a way to gaming the ring-fence if they don't have a strong disincentive to do so," he told the BBC.

"In 10-20 years time... people will get complacent. At that point it's crucial to have a set of rules to keep banks well away from testing this ring-fence."

Shadow chancellor Ed Balls said: "As Ed Miliband and I said at the Labour conference this year, if the letter and spirit of the Vickers proposals are not delivered and we do not see cultural change in our banks, full separation will be necessary.

"The Commission is clearly right to say the jury is still out and to demand a reserve power for full separation of the banks."

The Commission's report comes a month after Mr Osborne urged its members not to send the government's proposed reform "back to square one" by "unpicking" the consensus on how it should be carried out.

Business Secretary Vince Cable, who has often been at loggerheads with Mr Osborne over how tough banking reforms should be, said: "I think we originally came out at it from opposite directions, but we've come to a common view that the ring-fencing solution is the best way forward."

"I think he [George Osborne] is quite right to say the last thing we want is to create more uncertainty," he told the BBC.

'Perpetual uncertainty'

However, the banking industry was less enthusiastic about the proposals, saying lingering uncertainty about the future shape of the banking industry threatened banks' ability to lend and to compete.

"The risk here is creating uncertainty," Anthony Browne, the chief executive of the British Bankers' Association (BBA), told the BBC.

"If it's perpetually hanging over the banking sector that individual banks or the whole sector could be broken up at some point, then it's going to be difficult to return to having an investable banking sector that can be customer-focused and globally competitive and do what it should be doing, which is lending to homeowners and businesses."

Mark Field, a Conservative MP whose constituency includes the City of London, also warned of the dangers of uncertainty hanging over the banking sector. He said the 2019 deadline for banks to fully implement the reforms - as the Vickers report proposed - needed to be brought forward.

Mr Cable said the government wanted to "crack on with it".

"We want to make sure that by the end of this parliament we have something proper in place," he said.

"But if there are good proposals coming from parliamentarians to deal with the strengthening of the ring-fence - as Sir John said it has to be effective, that's the whole point of it - then we obviously will have to look at that."